Professional Documents
Culture Documents
Loughlin 1977
Loughlin 1977
INTRODUCTION Committee, 1950, p. 37] when (1) the total of all benefits
Recent investigationsof the proceduresfor analyzing fed- exceedsthe total of all costs,(2) the scale of developmentis
eral water resourceprograms have focusedon the evaluation such as to provide maximum total benefits over total costs,
and cost-sharingaspectsof project formulation. The recom- and (3) the benefits of adding each purpose as the last in-
mendations stemming from these studies have stressedthe crement at least equal the separablecostsof the added capac-
need for multiple objectives [U.S. l,Vater ResourcesCouncil, ity.
1973], a change in the discount rate [U.S. I4/ater Resources For project feasibility the overall benefit-costratio must be
Council, 1968], and increasedcost sharing for nonfederal en- greater than unity. This involves the comparison of totals
tities [National I4/ater Commission, 1973]. Although the (benefitsand costs),which precludesthe,necessityto allocate
method of cost allocation affects cost-sharingarrangements, joint costsamong purposes.In decidingthe optimal designof
no comparable researcheffort has been directed at the effi- a project, marginal or incremental analysis is employed to
ciency and equity of the various methodsfor allocating costs determine'that scale of development where marginal social
among project purposes.Congress,in the Water Resources benefitsare equalto marginalsocialcosts.As longasmarginal
Development Act of 1974 [U.S. Congress,1974, sect. 80(c)], benefits exceed marginal costs, an increase in the scale of
directed the Presidentto investigatethe principles and stand- development will increase net benefits. Since marginal costs
ards for the planning, evaluation, and cost sharing of water are independentof joint costs,a cost allocation is not neces-
resourceprojects; however, the 'plan of study' [U.S. Water sary to determineoptimal scale.Similarly, in decidingwhether
ResourcesCouncil, 1975] recently approvedby the U.S. Water to include a function in the project an incrementalanalysisis
ResourcesCouncil doesnot includea specificexamination of employed. As long as the additional benefits from including
cost allocation methods. The purposesof this paper are to the function are equal to or greater than the additional or
analyze the efficiencyand equity of various cost allocation separable costs of including the function, inclusion of the
methods and to suggestchangesin some of the methods to purpose is justified. The benefits of each purpose need only
meet these objectives. cover separablecosts,sincejoint costsare sunk and need not
be recouped.This eliminatesthe necessityfor purposebenefits
PROJECTEVALUATION,COST AI.I.OCATION, to cover a part of joint costsand therefore the needto allocate
AND COST SHARING joint costsamong functionsin decidingpurposejustification.
in discussingthe needto allocatecostsa distinctionmust be Do COSTS NEED TO BE ALLOCATED 9.
made between project evaluation, cost allocation, and cost
sharing. Project evaluation dealswith the estimationof bene- There is no need to allocate project costsamong purposes
fits and costsin order to determine project justification. Cost when (1) projects are single purpose, (2) multiple-purpose
allocation is concernedwith the distribution of total project projects are nonreimbursable,or (3) reimbursable multiple-
costsamong the various purposesservedby the project. Once purpose projectsare priced according to economicefficiency
costs are allocated, cost-sharingor reimbursementpolicy dic- principles in a situation where long-run average cost is not
tates what portion of purpose costswill be shared by federal falling. Prior to the 1930'stherewas little needto allocatejoint
and nonfederalentities.Although costallocationcan affectthe costs,becausevery few federal projectswere multiple purpose
degree of cost sharing, project evaluation and cost allocation in design. With the advent of the Flood Control Act of 1936
are consideredto be independentof each other. The economic [U.S. Congress,1936], however, the planning of projectsfa-
evaluation of a project in no way dependsupon cost alloca- vored multiple-purposedevelopmentbecauseof the cost sav-
tion, becausethe costsallocated to a project purposeare not ings from combining several purposesinto a singleproject.
The local reimbursement features of the Flood Control Act of
the coststo considerin decidingoverall project feasibility,the
optimal scale of development, or whether the purposeshould 1936 and subsequentlegislationnecessitateda costallocation
be included in the project. A project is economicallyjustified among purposes, so a subcommittee of the Federal Inter-
and properly formulated [Federal Inter-Agency Rit;er Basin Agency River BasinCommittee was formed to study ways in
which costs should be allocated. The findings of the cost
Copyright@ 1977 by the American GeophysicalUnion. allocation committee formed the basis on which the Sub-
committee on Benefitsand Costs [Federal Inter-Agency River adopted a modificationand extensionof the SCRB method for
Basin Committee, 1950] recommended the separable use in multiobjective and multipurposefederal and federally
costs-remainingbenefits(SCRB) method oF cost allocation. assisted reservoir projects [U.S. Water Resources Council,
The Federalagenciesin the past havegiven minimal consid- 1973]. Thus at presentall water resourceagenciesare applying
eration to assessingbeneficiariesFor project serviceson the the SCRB method in these types of programs. For multiple-
basis of rates establishedthrough competition. Ciriacy-Wan- purpose channel improvements, however, the SCS still em-
trup [1954] was an early exponent oF determining chargesfor ploys the useof facilitiesmethod [U.S. Departmentof Agricul-
project serviceson the basisoFsupplyand demand Functions. ture, 1974].
In recent years [Krutilla, 1966; Flannery, 1968; Hanke and
COST ALLOCATION METHODS
Davis, 1973] there has been a continuation oF interest in the
application oF marginal cost pricing techniquesto the pricing The SCRB method oF cost allocation assignsto each Func-
oF water resourceoutputs. Not only would such a pricing tion the separablecostsoF including the Functionin the mul-
schemelead to short- and long-run efficiency,but in the ab- tiple-purposedevelopmentplus a shareoFthe.joint or common
sence oF decreasingcosts and Full reimbursementoF project costsoFthe project. Joint costsare allocated on the basisoFthe
costs it would obviate the need to allocatejoint costs. Under remaining benefitsaccruingto each Function.A descriptionoF
such a pricing scheme, optimal use oF existing capacity For this allocation procedureis presentedin Table 1.
eachpurposewould be obtainedby settingprice at that output Table I assumesthat total project costs(row 7) amount to
levelwhere demand and short-run marginal costwere equal. IF $350,000 on an average annual basis and includesinvestment
at that output level the price, or marginal benefit to society, cost and operation, maintenance,and replacementcosts.Ben-
were greater than (less than) the long-run marginal costsoF efits, alternative costs,justifiable costs, separable costs, and
added capacity, an expansion(contraction) oFwater resource joint costs are also expressedon an average annual basis.
capacity would be warranted. This process oF adjustment Justifiable costs(row 3) are either the benefits or the alterna-
shouldcontinueuntil price is equal to long-runmarginalcosts. tive costsoFsingle-purposeprojectsproviding the samebene-
At the expanded or contracted level oF project size, price fits, whicheveris the lesser.Justifiablecostscan be interpreted
would alsobe equal to short-runmarginal costs.The optimal as the maximum coststhat an investorwould be willing to pay
scaleof developmentas well as the most efficient use of that to obtain a certain amount oF benefits.
optimal scalewould thus be achieved[Hirshleiferet al., 1960, Separable costs(row 4) are the differencebetween the cost
p. 97]. In the presenceof long-run decreasingaveragecostand oFthe multiple-purposeproject with the purposeincludedand
full reimbursementof project costs, however, application of the costwithout, and they are subtractedFromjustifiable costs
marginal cost pricing would return less than project costs. to arrive at remaining benefits. The subtraction oF separable
Some costswould have to be allocatedto purposesfor collec- costs Fromjustifiable costs is on a 1:1 basis, in contrast to a
tion of lump-sum paymentsfrom beneficiaries. method that weighs allocated separablecostsdifferently and,
Potential for the use of marginal cost pricing exists for the in effect, is a subtraction From justifiable costs on either a
pricing of municipal water services,industrial and municipal greater than or a lessthan 1:1 basis. Separable costsinclude
sewerage,navigation, and flood control [Hanke and Davis, ' not only the specificcostsof including the purpose, such as
1973]. Legislative restrictionson the application of user fees power turbines,transmissionlines, irrigation ditches,and nav-
and past agencypracticeslimit the use of competitivepricing igation locks,but also the addedcostsof a changein the sizeor
in the casesof recreation, fish and wildlife, irrigation, and design of the structure from inclusion of the purpose. For
hydroelectricpower. Until theseobstaclesare removed,it will example, the separablecost of flood control would include the
be necessaryto allocate project costsamong purposesto meet sluicewaysplus the costof increasingthe height of the dam to
statutory and administrative reimbursementrequirements. provide for adequate flood control storage.
Joint costs(row 6) are the differencebetween total project
COST ALLOCATIONAGREEMENTOF MARCH 12, 1954
costsand total separablecostsand are distributedamongeach
On March 12, 1954, an agreementwassignedby the Depart- function in the same proportion as that of the remaining
ment of the Interior, the Department of the Army, and the benefitsof eachfunctionto the total remainingbenefits.Total
Federal Power Commission (unpublished report titled 'Cost allocated costs for each purpose (row 7) are arrived at by
Allocation,' memo. 57981-2, Washington, D.C., March 1954) adding separablecostsand allocatedjoint costs.The benefit-
statingthat the SCRB method of costallocationwas the most cost ratio for the entire project is 1.4 (row I divided by row 7),
acceptablemethod of apportioningcostsamong multiple-pur- indicating an economicallyfeasibleproject.
pose developments.Under certain circumstancesthe agree- The savingsallocated to each purpose (row 8) from com-
ment provided that the alternativejustifiable expenditureand bining the purposesin a multiple-purposedevelopmentare the
use of facilities methods could be employed. Although the differencebetweenthe justifiable costsfor each purpose and
Federal Power Commission,the U.S. Army Corps of Engi- the total costsfor each purpose.Total allocated savingsfrom
neers, and the Bureau of Reclamation have relied on the multiple-purposedevelopmentamount to $50,000. These sav-
SCRB method almost exclusively,the TennesseeValley Au- ingsarisebecausethe average.costof larger reservoirsis lower
thority (TVA) and the Soil ConservationService(SCS) have than that for smaller reservoirsand becausethe same storage
favored the alternativejustifiable expenditureand the use of spacein multiple-purposereservoirsmay be used for two or
facilitiesmethods, respectively.TVA's cost allocation prefer- more functions.The first savingsarisesfrom a more efficient
ence stemsfrom a study conductedin 1938by the TVA Com- use of a given site, while the secondresultsfrom more efficient
mittee on Financial Policy [U.S. Congress,1938], while the use of existingfacilities.
SCS partiality for the use of facilitiesmethod is basedon its The alternative justifiableexpenditure methodof costallo-
ease of calculation and greater comprehensibility by non- cation is sometimesreferredto as the 'specificcosts-remaining
technical people [U.S. Department of Agriculture, 1964]. On benefits'method,sinceit substitutesthe specificcostsof the
September 10, 1973, the U.S. Water ResourcesCouncil various functionsfor their separablecosts.Specificcostsare
10 LOUGHLIN:COSTALLOCATIONMETHODS
Purpose
the costs directly attributed to the purposeand exclude the Allocated total costsequal the sumof allocatedjoint costsplus
costs of a change in project design due to inclusion of the separableor specificcosts.Table 3 presentsan exampleof the
purpose.Joint costsare arrived at by subtractingall specific use of facilities method.
costsfrom total project costs,and they are distributedamong The useof facilitiesmethodis consideredacceptablein those
the various purposes in proportion to remaining benefits. instanceswhere joint use is clearly determinableon a com-
However, with this formula, remainingbenefitsare calculated parative basis. However, becauseof the problem of finding a
by subtracting specificcosts from justifiable costs on a 1:1 common denominator for all purposes,it is usually recom-
basis. Total allocated costsare the sum of specificcostsand mendedonly for suballocatingcostsof a given function in a
allocated joint costs. An example of this procedure is illus- single-or multiple-purposedevelopment[Dominy, 1966,p. 9].
trated in Table 2.
THE EFFICIENCY AND EQUITY OF
The alternative justifiable expenditure method is recom-
COST AI.I.OCATION METHODS
mended in those instances where the data are not available for
estimatingseparablecost or when the cost of obtaining such Any cost allocation method employed should satisfy the
data would be prohibitive (unpublishedreport titled 'Cost objectivesof economic efficiencyand equity. The conditions
Allocation,' memo. 57981-2, Washington,D.C., March 1954, for efficiencyin cost allocation can be stated as follows [U.S.
p. 1). A seriesof cost estimatesshowingthe multiple-purpose Department of Agriculture,1964,chap.10,p. 5; U.S. Departmentof
project with and without each purposecan be quite expensive. the Interior, 1959,p. 116.5.12]:(1) the separablecostof adding
Since it relies on specificcostsrather than separablecosts,the each purpose as the last increment should not exceed the
alternative justifiable expenditure method is much easier to benefitsderived therefrom, (2) the sum of the total costsallo-
calculate than the SCRB method. cated to each purposeshouldnot exceedthe sumof the total
The use of facilities method of cost allocation attempts to benefits allocated to each purpose, and (3) the total costs
allocate joint costs in proportion to the relative use of the
common facilities by each purpose. It thus distributesjoint
costsin proportion to physicalcriteria rather than benefitsas TABLE 2. Alternative Justifiable Expenditure Method of Cost
in the two previousmethods.Such measuresas reservoirstor- Allocation
TABLE 3. Use of Facilities Method of Cost Allocation Institute,1958,p. 79]. Oncecostsare allocated,equityin cost
sharingis thenconcerned with the distributionof benefitsand
Purpose local costsamong users.The 'fairness'conceptof equity in
Item Description A B C Total cost allocationhasbeenemphasizedby the Subcommitteeon
Benefitsand Costs: 'The objectiveof cost allocation is to
I Benefits 300 250 150 700 distributeprojectcostsequitablyamongthe purposesserved
2 Specificcosts 60 40 20 120 ß.. by providingfor proportionalsharingof thesavings result-
3 Total storage,ac ft 5,000 3,000 2,000 10,000
4 Allocatedjoint costs* 200 120 80 400
ing from multiple-purpose development' [FederalInter-Agency
5 Total ailocatedcosts(2 + 4) 260 160 100 520 RiverBasinCommittee,1950,p. 53]. A similarnotionof equity
in costallocationis providedin the U.S. Bureauof theBudget
Values are in thousandsof dollars exceptwhere it is otherwisein- [1952, p. !1] CircularA-47 and SenateDocument97 [U.S.
dicated.
Congress, 1962,p. 12].Thiscriterion,however,is not satisfied
*Total joint costsof $400 (projectcostof $520 minustotal specific
costof $120) are allocatedto eachpurposein the sameratio as that of by any of the threecostallocationmethods,becauseat least
the storageassignedto eachpurposeto the total storage. two proceduralproblemsexistwhichdo not providefor pro-
portional sharingof project savingsamong purposes.One
sourceof inequitycommonto the SCRB and the alternative
allocatedto each purposeshouldnot exceedthe costof a justifiableexpenditure methodsarisesbecause eitherseparable
single-purpose alternative providing equivalent benefits.All or specificcostsare subtracted from justifiablecostson a 1:1
threeefficiency criteriaare satisfiedby the SCRB method. basis.The questionof the proprietyof thisprocedurehasbeen
However,the alternativejustifiableexpendituremethodand raised elsewhere[Thrall, 1963]. A further equity problem
the use of facilitiesmethod employing specificcostsdo not arisesin attemptingto definecapacitywhenoneis applyingthe
necessarily satisfycondition(1) in thoseinstances wheresepa- use of facilities method.
rablecostsare greaterthan specificcosts.In thesecasesit is To illustratethe first proceduralproblem in apportioning
possiblethat thebenefits
of includinga purposemaybeequal costs, reference is made to Table 1. To obtain remaining
to specificcostsbut lessthan separablecosts.The purpose benefitsfor joint costallocationpurposes,separablecostswere
wouldbejustifiedon the basisof specificcostsbut infeasible subtractedfrom justifiablecostson a 1:1 basis.Inasmuchas
on the basisof separablecosts.Sincethesemethodscannot separable costsare deductedon a 1: I basis(on the assumption
assurethat the separablecostsof addinga purposewill not that thejustifiablecostsfor eachpurposeare equal),the proj-
exceed the benefitsderived from its inclusion in the project, ect savingsallocatedto eachpurposeare not proportionalto
they fail one of the efficiencytests. the savingsfrom inclusionof eachpurposein the project.This
Moreover, the useof facilitiesformula doesnot employthe situation resultsbecausethe separablecostsof adding a pur-
conceptof justifiablecosts,whichplacesan upperlimiton the poseproducepart or all of the savingsfrom multiple-purpose
costsapportionedto a particularpurpose.Inasmuchas this development, yet the separablecostsdo not sharein the sav-
methodallocates joint costson the basisof physicalcriteria,it ingsallocatedto eachfunction.By not creditingtheseparable
ispossiblefor a purpose to beassigneda shareof multipurpose costswith a part of project savingsvia the subtractionof
costsin excessof the costof obtainingthe samebenefitfrom a separablecostsfrom justifiablecostson a greaterthan 1:1
single-purpose alternative[Dominy,1966,p. 7]. For example, basis, all project savingsaccrueentirely to the joint costs.
in Table 3 the total allocated costsfor purposeA amount to Equityin costallocationdictatesthat the savingsallocatedto
$260,000, althoughthe cost of a single-purpose alternative eachfunctionbe proportionalto thesavingsfrom inclusionof
mightbe $250,000.Thereis thereforeno guaranteethat crite- each function in the project.
rion (3) will be met by the useof facilitiesmethod.Sincethe The projectsavingsallocatedto purposes A, B, C, and D in
alternativejustifiableexpenditure and useof facilitiesmethods Table I amounted to $4,000, $10,000, $16,000, and $20,000,
of costallocationdo not necessarily satisfyall threeefficiency respectively.
The savingsfrom includinga purpose,asthe last
criteria, the SCRB methodisjudgedsuperioron the basisof increment,are definedas the savingsin projectcostsattributed
the efficiencyobjective. to inclusionof the purposein excessof the project savings
Equityasan objectiveof projectevaluation,costallocation, obtained from constructinga project consistingof all other
and costsharinghas two meaningsin economics:redistribu- purposes. Rows3, 10, 11,and 12 indicatethe computationof
tion and fairness[MarshallandBroussalian,1971,p. 201]. The the savingsfrom inclusionof a purposein a multiple-purpose
first interpretationhasbeenappliedto projectevaluationand development.For example,the savingsfrom addingpurpose
cost sharing,the secondto cost allocation. In project eval- A (row 12) can be found by adding the justifiablecostsof a
uation,equityrefersto the redistributionof netbenefitsamong projectmadeup of functionsB, C, and D (row 11) and the
beneficiariesof a program. A favorableredistributionoccurs justifiablecostsof purposeA (row 3) and subtractingtotal
when beneficiariesin low per capita incomeareasreceivebene- projectcosts(row 7). The needto estimatethejustifiablecosts
fits from a programthat are proportionallygreaterthan the for a projectwith purposeA deletedresultsfrom the fact that
localcostsof the program.Equity in costsharingcan thusbe part of the total projectsavingsmay be obtainedby construct-
achievedby loweringthe local costsharesin theselow-income inga projectcombiningall otherpurposes. The otherpart of
areas in relation to the benefitsreceived[Marshall and Brous- total projectsavingsresultsfrom the inclusionof purposeA.
salian, 1971, p. 216]. Thus functionA produces$20,000of savingsfrom inclusionin
With regardto cost allocation,equity refersto fairnessin the multiple-purpose development,the other $30,000of total
the distributionof total project costsamongall the purposes projectsavingsbeingprovidedby a projectconsisting of func-
servedby a multiple-purposedevelopment.Specifically,an tions B, C, and D. Since the savingsattributed to adding
equitablecostallocationis onewhich permitsall projectpur- purposeA are $20,000,thisindicatesthat the separable costsof
posesto share fairly in the savingsfrom multiple-purpose includingpurposeA producedthe $20,000of projectsavings.
rather than single-purpose construction[StanfordResearch Similarly, purpose D provides$50,000 of savingsfrom in-
12 LOUGHLIN: COST ALLOCATION METHODS
Purpose
coststo reflecttheassignment
of a portionof projectsa•,ings
to ings arising from multiple-purposedevelopment. The source
the separablecosts.This adjustmentwould decreaseremaining of inequity with the SCRB and alternative justifiable ex-
benefits,joint costs, and total coststo those purposeswith penditure methodsarises becauseeither separableor specific
higher separablecosts.Sinceallocatedsavingswould increase costsare subtractedfrom justifiable costson a 1:1 basis.With
to those purposeswith higher separablecosts,a more propor- a simple adjustment in these two methods, equity in cost
tionate relationshipbetweenthe savingsallocatedto eachpur- allocation can be obtained. The use of facilities method pre-
pose and the savingsfrom purpose inclusion would emerge. cludesthe possibilityof a fair sharingof project savingsamong
The computation of the credit and its effect on the allocation purposesbecauseof conceptualproblemsin definingreservoir
of costsis presentedin Table 4. As a resultof this changein the use. No adjustmentin the useof facilitiesmethod can achieve
SCRB method, each purposeis assigneda more proportional equity in cost allocation.
share of the savingsresultingfrom multiple-purposedevelop- A modificationof the SCRB method is proposedwhich will
ment. For example, the inclusion of purpose A causedap- enable this method to satisfy both efficiencyand equity cri-
proximately a 12%increasein project savings,while purposeA teria.Theproposed
change
in thecostallocation
procedure
now sharesin 14%of allocatedsavings.Similarly, the addition would apply a credit to separablecostsin the same ratio as
of purposesB, C, and D causeda 29% increasein project that of the justifiable costsfor a purpose plus the justifiable
savings for each, whereas their adjusted share of allocated costsfor all other purposesto the total projectcosts.The effect
savingsamounts to 27%, 29%, and 30%, respectively.A more of this changewould be a tendencyfor the savingsallocatedto
equitableallocation of project savingsis achievedby crediting each purposeto bear a more proportionate relationshipto the
the separablecostswith a part of project savings. savingsfrom inclusionof each purposein the project.
Although other adjustmentsin the SCRB method, including
the forcing of proportionality, could achievesimilar or better Acknowledgments. The author wishesto expressappreciationto
results, such changesmight not be consistentwith the SCRB Harold E. Marshall and to an anonymousreferee for helpful com-
conceptor administrativelyworkable. For example, the forc- ments on a previous draft.
ing of proportionality would necessitatethe forcing of allo-
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14 LOUGHLIN:COSTALLOCATIONMETHODS
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